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When Should Asset Appreciation Be Taxed?: the Case for a Disposition Standard of Realization†

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When Should Asset Appreciation Be Taxed?: the Case for a Disposition Standard of Realization† When Should Asset Appreciation Be Taxed?: The Case for a Disposition Standard of Realization† * JEFFREY L. KWALL INTRODUCTION ........................................................................................................ 78 I. EVOLUTION OF THE REALIZATION REQUIREMENT ................................................ 82 A. THE INFANCY OF REALIZATION—SHOULD ASSET APPRECIATION EVER BE TAXED? .......................................................................................................... 83 B. THE YOUTH OF REALIZATION—THE NECESSITY OF A CONTEMPORANEOUS BENEFIT.......................................................................................................... 85 C. THE MATURITY OF REALIZATION—EROSION OF THE CONTEMPORANEOUS BENEFIT REQUIREMENT ................................................................................. 87 D. A PARALLEL STRAND—IS A “DISPOSITION” SUFFICIENT FOR REALIZATION? ................................................................................................ 89 II. POLICY IMPLICATIONS OF A DISPOSITION STANDARD FOR REALIZATION ............ 91 A. DISPOSITION STANDARD MITIGATES INEQUITY AND INEFFICIENCY OF CURRENT LAW ............................................................................................... 92 1. EQUITY CONSIDERATIONS .................................................................. 92 2. EFFICIENCY CONSIDERATIONS ........................................................... 94 B. DISPOSITION STANDARD MITIGATES ADMINISTRATIVE AND POLITICAL PROBLEMS POSED BY A MARK-TO-MARKET SYSTEM..................................... 96 1. VALUATION ........................................................................................ 96 2. LIQUIDITY .......................................................................................... 98 3. POLITICAL FEASIBILITY ...................................................................... 99 C. DISPOSITION STANDARD SIMPLIFIES THE LAW ........................................ 100 III. IMPLEMENTATION OF A DISPOSITION STANDARD ............................................. 101 A. STATUTORY CHANGES ............................................................................. 101 B. COMPARISON OF CURRENT LAW TO DISPOSITION STANDARD ................. 102 1. SALE OF APPRECIATED PROPERTY ................................................... 102 2. EXCHANGE OF APPRECIATED PROPERTY FOR OTHER PROPERTY ..... 103 3. EXCHANGE OF APPRECIATED PROPERTY FOR PAST OR FUTURE SERVICES ............................................................................................. 104 4. TRANSFER OF APPRECIATED PROPERTY PURSUANT TO DIVORCE .... 105 5. CHARITABLE CONTRIBUTION OF APPRECIATED PROPERTY .............. 106 6. INTER VIVOS GIFT OF APPRECIATED PROPERTY ............................... 109 7. TRANSFER OF APPRECIATED PROPERTY AT DEATH .......................... 111 8. TRANSFER OF DISTRESSED PROPERTY TO LENDER—DEED-IN-LIEU OF FORECLOSURE, ABANDONMENT, FORECLOSURE ................................. 113 9. DESTRUCTION OR THEFT OF APPRECIATED PROPERTY ..................... 116 † Copyright © 2011 Jeffrey L. Kwall. * Kathleen and Bernard Beazley Professor of Law, Loyola University Chicago School of Law. B.A., Bucknell University; M.B.A., The Wharton School; J.D., University of Pennsylvania Law School. The author thanks Sam Brunson, Glenn Coven, Marjorie Kornhauser, Ajay Mehrotra, Anne-Marie Rhodes, and Larry Zelenak for helpful comments on earlier drafts. I also thank my student assistants Hillary Luegers, Bradley Phipps, Kathleen Przywara and Courtney Karamanol for their excellent work. This project was supported by a Loyola University Chicago School of Law summer research grant. 78 INDIANA LAW JOURNAL [Vol. 86:77 10. NON-DISPOSITIONS: MORTGAGE, PLEDGE, OPTION, PARTITION .... 117 CONCLUSION.......................................................................................................... 117 The realization requirement is one of the most basic elements of the United States income tax. Due to this requirement, any increase in the value of a person’s property is not taxed when it occurs. Rather, the tax on asset appreciation is deferred until the occurrence of a realization event; that is, until the property is transferred in exchange for money or other consideration. By contrast, all other forms of income (e.g., salary, rents) are taxed immediately. The realization requirement is inequitable because it causes asset appreciation to be taxed more favorably than other forms of income, thereby violating the normative goal of taxing all forms of income alike. The realization requirement is also inefficient because it favors investments generating economic returns in the form of asset appreciation (as opposed to periodic returns), thereby violating the normative goal of imposing taxes that do not distort investment decisions. In addition, the realization requirement adds complexity to the tax system and sacrifices potential tax revenue due to the deferral it confers. In light of the inequity, inefficiency, and complexity of the realization requirement, the requirement should be modified. Reformers have long argued that asset appreciation should be taxed as it occurs under a mark-to-market system. However, taxing asset appreciation as it occurs presents serious administrative problems because it requires an annual assessment of the value of every taxpayer’s assets. In addition, strong political resistance exists to taxing “paper gains.” For these reasons, it is unlikely that a comprehensive mark-to-market system will ever be adopted. Due to the dim prospect of adopting a mark-to-market system, this Article proposes the adoption of a “disposition” standard of realization. That standard would treat every transfer of property as a realization event regardless of whether the transferor receives consideration for the transferred property. Unlike current law, the disposition standard would tax lifetime gifts, as well as testamentary transfers, of appreciated property. A disposition standard is a second-best alternative to a mark-to-market system. This new standard would curtail the inequity and inefficiency of the current realization requirement while posing less significant administrative and political problems than a mark-to-market system. In addition, the disposition standard would simplify existing law by substituting a clear and administrable set of rules for the current ambiguous and anachronistic system. Finally, a disposition standard should help to generate much needed tax revenue. INTRODUCTION For almost a century, the United States has utilized an income tax as a major revenue source.1 From an economist’s perspective, an income tax should tax any 1. Shortly after the Sixteenth Amendment was ratified, Congress passed the Tariff Act of 1913. U.S. CONST. amend. XVI; Tariff Act of 1913, ch. 16, 38 Stat. 114. Earlier versions of the income tax date to the Civil War years. See, e.g., Act of Aug. 5, 1861, ch. 45, § 49, 12 2011] A DISPOSITION STANDARD OF REALIZATION 79 increase in a taxpayer’s wealth when it occurs.2 Accordingly, asset appreciation should be taxed as it occurs. The U.S. income tax, however, has always embraced a realization requirement, thereby deferring the taxation of asset appreciation until the occurrence of a realization event (normally, a sale or exchange of the appreciated property).3 The realization requirement has evolved in an unprincipled manner and remains ambiguous to this day.4 When the U.S. income tax originated, neither Congress nor the courts debated the question of whether asset appreciation should be taxed as it occurred, or instead deferred until realization.5 Rather, the early courts were embroiled in a controversy over whether increases in the value of property should ever be taxed.6 As such, the law has always been slanted toward deferring the tax on asset appreciation. Initially, the realization requirement was seen as a constitutional mandate.7 The jurisprudence that emerged from this view regarded realization as requiring the Stat. 292, 309. In 2008, federal-income-tax collections totaled more than $1.42 trillion. Table 1. Internal Revenue Collections and Refunds, by Type of Tax, Fiscal Years 2007 and 2008, http://www.irs.gov/pub/irs-soi/08dhb01co.xls. 2. See HENRY C. SIMONS, PERSONAL INCOME TAXATION 50 (1938) (“Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question.”); ROSWELL MAGILL, TAXABLE INCOME 18 (rev. ed. 1945) (“Income is the money value of the net accretion to economic power between two points of time.” (emphasis omitted)). 3. See infra Part I (discussing the evolution of the realization requirement in U.S. tax law). 4. See Marjorie E. Kornhauser, The Story of Macomber: The Continuing Legacy of Realization, in TAX STORIES 93, 95 (Paul L. Caron ed., 2d ed. 2009) [hereinafter Kornhauser, The Story of Macomber] (“Although realization is a basic concept in our income tax laws, its exact parameters are hazy.”); Marjorie E. Kornhauser, The Constitutional Meaning of Income and the Income Taxation of Gifts, 25 CONN. L. REV. 1, 48 (1992) [hereinafter Kornhauser, Constitutional Meaning] (“[W]hat is realization? . [T]here is no one definitive answer . .”); Deborah H. Schenk, A Positive Account of the Realization Rule, 57 TAX L. REV. 355, 358 n.8 (2004) (“‘Realization’ does not have a fixed meaning. There is no statutory definition and our
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